Working Capital Management

1. Working Capital Management Accounts Payables Lecture By Imran Khan

2. What is a current liability? A current liability is an obligation that is: • Due within one year of the date of a company's balance sheet and • Will require the use of a current asset

3. What are the two major types of current liabilities? • Accruals (Amounts unaccounted for yet still owing at the period or year end) • Accounts Payable Accruals are those items where • The benefits have already been taken by the company but the payments are not yet made. • Example: Rent accrued for previous 6 months but not yet paid.

4. Objective • The objective of payables management is to ascertain the optimum level of trade credit to accept from suppliers.

5. Accounts payable arise from trade credit and are a spontaneous form of credit. • Credit terms may vary among industries and among companies, although these tend to be similar within an industry because of competitive pressures.

6. How to balance payables? • Deciding on the level of credit to accept is a balancing act between liquidity and profitability.

7. Problems By delaying payment to suppliers, firms suffer from possible problems: • supplier may refuse to supply in future • supplier may only supply on a cash basis • there may be loss of firm’s reputation • supplier may increase price in future.

8. Credit Policy • Firms have their own credit policy for selling on credit. • The policy states certain terms of credit.

9. Example of the cost of trade credit • Bailey company sells on credit with terms of 2/ 10, net 30. • This means that it gives its customers a 2% discount if they pay within 10 days of the invoice date but the full invoice amount is due to be paid within 30 days if the discount is not taken.

10. Nominal cost of Trade Credit • Nominal Annual cost= Discount % * 365days 100- Discount % Days credit is outstanding- Discount period

11. Effective Annual cost of Trade Credit Rate = Discount % 100- Discount % Effective Annual Rate= (1+i)ⁿ - 1

12. Question-1 What is the nominal and effective cost of trade credit under the credit terms of 3/ 15, net 30?

13. Question-2 A large retailer obtains merchandise under the credit terms of 1/ 15, net 45 but routinely takes 60 days to pay its bills. Given that the retailer is an important customer, suppliers allow the firm to stretch its credit terms. What is the retailer’s effective cost of trade credit?

14. Question Cole United sells on a 1/ 10, net 30 basis and has sales of $18,250,000. per year. All sales are for credit. 15% of all sales are paid on the 10th day and the rest are paid in an average of 40 days. Production costs are 80% of the sales price. Assume a 365-day year. • Employing these probabilities of occurrence, what is the average collection period? • What is the average investment in accounts receivable?

15. Question A chain of appliance stores, APP corporation purchases inventory with a net price of $500,000 each day. The company purchases inventory under the credit terms of 2/ 15, net 40. APP always takes the discount but takes the full 15 days to pay its bills. What is the average accounts payable for APP?

16. Question Mc. Dowell Industries sells on terms of 3/ 10, net 30. Total sales for the year are $912, 500. 40% of the customers pay on the 10th day and take discounts, the other 60% pay on average , 40 days after their purchases. • What is the days sales outstanding? • What is the average amount of receivables? • What would happen to average receivables if Mc. Dowell toughened up on its collection policy with the result that all non-discount customers paid on the 30th day?